Memo: Gen Z Arbitrage

For those with Android-based smartphones in 2010, you may recall a fear of missing out. For iPhone owners who had access to a fledgling startup called Instagram, they made sure to remind you that your phone was incapable of using the software. Nothing matched the aesthetic or network effects of the photo-sharing platform for the rich kids. The fear of missing out moved many to leave Android for iOS. For those who couldn’t, Apple’s products lived – rent free – in their minds until they too had the opportunity to own their very own iPhone. This was Apple’s strategy and there’s a chance that it wouldn’t have been executed without John Doerr’s vision for Steve Jobs and his app store.

In 2008, Kleiner Perkins Chairman and partner John Doerr recognized the transformative influence that the iPhone’s launch would provide for the mobile software industry. As the story would go, Steve Jobs privately discussed the prospects of the iPhone’s fledgling app store with Doerr. Jobs originally viewed the marketplace as a private entity, one that would remain under the complete control of Apple’s management. Doerr had different plans. He believed that by outsourcing the development and marketing of apps to third party teams of software engineers, Apple would build an effective moat around their mobile operating system.

Eventually, Jobs obliged. He agreed with the ecosystem lock-in potential of tens of thousands of software engineers building products for Apple’s new mobile operating system. Managed by Kleiner’s Matt Murphy (now with Menlo ventures), the $100 million iFund launched in 2008 and was later doubled to $200 million. Kleiner’s commitment to the burgeoning mobile software industry directly and indirectly impacted consumerism forever. Numerous venture firms identified the massive opportunities that mobile applications would provide and billions in venture capital followed suit.

Leading iPhone apps in the Apple App Store in the United States | Source: Priori Data

Just as Kleiner’s pioneering iFund once inspired an arbitrage that even Steve Jobs couldn’t have anticipated, the iPhone is once again at the center of an equally critical opportunity. As of March of 2019, the iPhone had an installed base of around 193 million in America. An astounding number given that the United States population is estimated to be around 372 million. By 2021, 45.4% all Americans are projected iPhone users.

China already is outpacing the U.S. and much of the developed world in mobile payments, and a new digital currency that authorities say would be like cash and accepted everywhere would put China miles ahead in the currency space. [1]

Apple’s app store helped to solidify the iPhone as perhaps the most pivotal consumer product of the early 21st century. One that powered transportation, communication, advertising, and global commerce. But nearly 12 years later, America’s commerce adoption still lags behind other global powers. Consider China, a country that achieved 73.6% digital shopper penetration in 2018. Mobile payments continue to drive the vast majority of online retail activity in the Asian country.

The rise of mobile payments in China

As a result, over 35% of all retail sales in China are done through online retail channels. In the United States, online retail adoption hovers at 12%. Mobile payments are commonplace throughout China across age, geography, and economic status. The ability to buy and sell goods online is so commonplace that Generation Z is the leading market for online luxury shopping in China. This has been bolstered by explosive growth in mobile payments over the past five years, a transaction volume that reached $45.1 trillion in 2018. According to the People’s Bank of China, this figure grew 28x in five years. It was largely driven by a cultural shift that saw China’s youth (Generation Z) empowered to transact for goods and services across China’s online retail and media ecosystem. According to Chinese media, proximity payment platforms Alipay and WeChat account for nearly 90% of the transactions. In America, there are 61.9 million proximity payment users, transacting just 113.79 billion in retail sales according to Statista’s 2019 data.

The Retail Arbitrage Ahead

Generation Z is the largest, youngest, most ethnically-diverse generation in American history. With over 82 million members, this cohort comprises over 27% of the US population.

While China’s Generation Z is more active in the purchase of consumer goods than their American counterparts, a snapshot of Gen Z’s current buying power would likely surprise you. TransUnion studied the credit market for buyers between the ages of 18 and 23 between Q2 2018 – Q2 2019. In that year, this consumer cohort accounted for 319,000 mortgages, 746,000 personal loans, 7.75 million credit cards, and 4.37 million auto loans.

Penetration rate of online luxury shopping in China | OC&C

Nearly 27% of Americans (and growing) fall within the birth years of Generation Z, a demographic that is of critical importance to legacy retailers and DTC brands, alike. In China, a country often measured as a leading indicator for American commerce trends, Generation Z leads in luxury retail adoption. In America, Generation Z is awaiting the opportunity to buy with the frequency of Millennials and Generation X. The data suggests that their consumer activity will trump that of previous generations. While Millennials prefer DTC brands by a margin of just 4% over traditional retailers, Generation Z prefers these online-born brands to their legacy counterparts by over 40-45%.

Gen Z, the group born between the mid-1990s and 2010, is already known for its financial literacy. More mature and pragmatic than its older millennial forbearers, the cohort is savvy with both finances and technology, survival skills that members gained after watching siblings and parents suffer through the 2008 recession. [2]

These are the brands that they’ve grown up with on social channels used over their iPhones: Snapchat, TikTok, WhatsApp, Instagram and others. The DTC arbitrage in 2020 and beyond will be closely tied to mobile payments. The growing adoption of CashApp, Venmo, and teenage banking programs like Current may begin to help Americans close the gap between the US v. China mobile payment adoption rates. At the center of this activity is Apple Pay, the tool with the most potential to influence Gen Z’s retail habits.

No Title

Online retail / DTC arbitrage:2008: Shopify over custom builds2012: Warby’s PR playbook2014: Facebook advertising2016: Key affiliate partnerships 2018: Selling the first $3-5M w/o ads

Generation Z is as technologically dependent as Generation X is physically independent. Whereas all day bicycle excursions and unannounced sleepovers were a fixture in the 70’s and 80’s, that is much less so today. The meeting places and opportunities are increasingly presented in the form of digital layers. In that way, millennial parents have had to come to terms with moderating a new era of independence. Fewer drivers licenses and cars, more subscriptions and teen banking accounts.

Alexis is a middle school-aged girl in the American Midwest. An A student, athlete, and all-around great kid, she tends to earn extra privileges from time to time. Equipped with her Apple Pay-enabled iPhone, her love of TikTok and Instagram, her fascination with Glossier and Athleta, and a bit of granted independence – she’s transacted $113.41 with Glossier and Athleta’s cart in the first three quarters of 2019. The limiting factor has been her access to funds, a constraint that Apple will likely account for by offering a peer-to-peer subscription product. Apple Pay provides an independence that Americans are still dueling with. But that’s evolving. Parents are trusting of their children maintaining cash balances on their mobile phones, especially if they can easily monitor spend and availability.

If you ask the founders of Warby Parker how the team scaled so quickly, they may mention the low costs of Facebook and Instagram ads at the time. They may cite the savvy public relations work that led to that magnanimous GQ article. This moment was responsible for the  initial sell-through of their first run of prescription glasses.

70% of Gen Z has made in-app mobile payments in the last year. More than any other generation. [3]

From time to time, there are technological and economic advantages that lift the brands that are prepared for the moment. For direct to consumer brands, a category of brands that Gen Z prefers over traditional retail, there is an opportunity to shorten the marketing funnel by appealing to a generation of consumers that have been written off by the incumbents in retail. Traditional brands are marketing to the parents of America’s youth rather than directly communicating to a demographic that could benefit them. The data suggests that as Apple Pay’s adoption rates continue to improve, Gen Z will become the primary consumers of the goods that have, so far, been marketed to Millennials and Gen X members.

Year 2020

We underestimate the significance of the Apple card being used as a function of the Family Share, a program that allows Apple users to share access to digital products and assets with their families. The moment that ‘Gen Z’ is capable of spending (while accountable to their parents) is the moment that 27% of American consumers, with a preference for DTC brands, floods the market. This is the potential arbitrage that awaits for this era of retail.

And in this way, this small shift in corporate strategy resembles the magnitude of moment that John Doerr was responsible for. Either Apple will build a native function that allows guardians to ‘subscribe’ and account for potential monthly allotments to their dependents. Or a third-party solution will be engineered by an outside developer. Of all the mobile payment solutions available to consumers, it is Apple that sits at the trusted intersection of family and finance.

The Apple card is a platform that few have recognized. It’s also another lock-in opportunity, perhaps the first of the Tim Cook era. With few exits, low multiples, and increasing customer acquisition costs – the weakening viability of the DTC ecosystem has been difficult for operators and investors alike. By accelerating Gen Z’s path to becoming independent consumers, Apple stands to benefit during a time where the Cupertino-designed hardware is as commoditized as ever.

And like Silicon Valley benefited from Apple’s democratization of the app store in 2008, this era of consumer brands will stand to benefit from democratization of consumerism within the home. Our Gen Z daughters want Balm Dotcom.

Read the No. 330 curation here.

Research and Report by Web Smith | Edited by Tracey Wallace | About 2PM 

No. 329: The MLM-ification of DTC

On Mavely and the unspoken opportunity ahead for the DTC industry. When Greats Brand was reportedly acquired by Steve Madden after their most recent year that saw $13 million in earnings, it was a shock to many in the industry. Revenues seemed lower than what many expected but inline with the realties of buildng an omnichannel brand with an often-costly means of customer acquisition. It’s likely that profitability was an issue. This begs the question, how would things have been different if Greats’ customer acquisition model was one built on profitability and value? The venture-dependent, high growth model may elevate a select few brands in the ecosystem but it seems to be depressing the exit optionality of the majority of them.

Percentage of ad spend is a fine tool for aligning incentives. The problem is not with tested and vetted agencies. It’s with bad ones using it to pad income before providing value.

Marco Marandiz

Founded by Ryan Babenzien, Greats was considered a well-respected, independent shoe company with great propects to become a brand as promising as Allbirds. Babenzien’s marketing team had command over several types of outreach. Greats employed several methods to include performance marketing, direct mail, strategic partnerships, and even text-based promotion. But in the end, the brand never achieved profitability. It was a stark reminder that we may be turning a corner in the DTC space; there seems to be an added weight to the importance of earning profits. A rebuke of the SaaS multiple model that many tech companies can adopt to grow in value. At the intersection of growth and profitability, its the street named ‘Profitability’ that DTC brands should run along.

Greats, which still sells most of its shoes through its eCommerce site, opened a 500-square-foot location on Crosby Street last year. The brand also inked a wholesale partnership with Nordstrom and unveiled a buzzy collaboration with men’s fashion authority Nick Wooster.[1]

The company seems to have done everything right and yet, Greats reportedly sold for no more than two times the previous year’s revenues (June 30, 2018 – June 30, 2019). Greats raised $13 million in funding and sold for around a reported $26 million. It became abundantly clear that an absent path to profitability became the issue that drove the wedge. Steve Madden’s supply chain and organization will be a great fit for this reason, the company drove north of $410 million in the previous year. And they did so while maintaining profitability.

We want to build a profitable business and we’re one of the few digitally-native brands that hasn’t raised an ungodly amount of money that makes it challenging to build a profitable business and exit where everybody wins. We weren’t trying to build the company that had the biggest valuation in round one. We’re trying to build the company that had the biggest valuation at the end. [2]

The news of this acquisition served as a wakeup call for many in the direct to consumer space. What else can be done to improve the viability of DTC brands? Is an early-stage path profitability that crucial? If there is one thing that’s clear, the days of optimizing for ‘at any cost’ growth may be over. As customer acquisition costs continue to skyrocket, retail media has begun reporting on several marketing alternatives. Of them is Mavely, a relatively new platform that launched with a unique approach to reducing CAC for these brands. Mavely’s big idea: turn these DTC brands into multi-level marketing companies.

Mavely is trying to put a new spin on the multilevel-marketing model, in which companies recruit people to sell for them but which has gotten a bad rap for leading a lot of people to actually lose money. Wray said Mavely has no cost to join, no inventory requirements that consumers must maintain, and no minimum follower count that users need to recommend products. [3]

Founded by Evan Wray, Peggy O’Flaherty, and Sean O’Brien, the Chicago-based company has raised $1 million and is reportedly profitable “on a per user basis.” The app-based service has 10,000 users and currently operates as a glorified, peer-to-peer affiliate model. But while it may eventually and significantly supplement organic and paid growth for brands, that timeline is likely to be longer than Mavely would care to admit. Critical mass for this type of service means that Mavely will have to earn tens of millions of users. It will be interesting to observe whether or not Wray’s company can remain committed to growing the way that they’re preaching to their DTC partners: cost-effectively, perhaps a bit slowly, and by one customer (down-line) at a time. In the meantime, the performance marketing industry may be due for an evolution of its own.

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I’m not sure that a lot of DTC brand owners realize that they’re building companies valued at 1 – 1.5x revenues.

In a recent conversation on the merits of percentage of ad spend as a profit center for media buying agencies, agency owner David Hermann provided his perspective on how business should be pursued between DTC brands and agency partners.

This is why we do percentage of revenue tied to ROAS that’s based on their margins and what the break even point is after costs associated with our fees and expenses. Trust is key, we lay everything out before we get started so they never are in dark on anything. [4]

It presented a worthwhile question. As institutional investors continue to pour more and more venture capital into the DTC space, the approach to marketing should evolve with the volume. CAC has risen as a result of an influx of capital spent on performance marketing. This cycle has led to an unintended result; larger but largely unprofitable businesses. Perhaps the math of success or failure should be reconsidered by investors and founders, alike. What Hermann suggests is correct, agencies should consider a new model for compensation – one that emphasizes healthy contribution margins for these retailers.

Hermann went on:

[My firm is] dealing with one client’s margins right now. [We’re] helping them find a better supply chain. They needed a 2.15x margin just to break even after fees and expenses, so I am now helping on their margin-side. As I always say, media buying is just one side of the job now.

There is an opportunity for a new style of performance marketing agency. Agencies equipped with brand-side, practical expertise could build acquisition strategies around healthy margins, paving the way for percentage of profits as the key performance indicator shared between DTC brands and their agency partners. This solves several problems. Of those concerns, this model accounts for: (1) sustainability, (2) efficient paths to profitability, (3) longer-term relationships between agencies and brands, and (4) decreased dependence on institutional capital. Rather than media buyers being compensated for what they spend, agencies should consider compensation on the profits that they earn for brands.

It’s acquisition vehicles like Mavely, BrandBox, DTX Company’s Unbox, and Showfields that may influence this shift in the agency business model by providing meaningful opportunities for CAC diversification. And if so, the DTC era may finally begin to solve its profitability problem. This could be the first step towards improving valuation multiples and exit optionality for an industry in need of another feather in its cap.

Report by Web Smith | About 2PM

 

No. 328: Open Letter to DTC Founders

It’s common for consumers to lose affinity for a brand. We grow older and more practical. Perhaps our lives evolve and children enter or exit the picture. Our bodies change and so do our minds. Our sensibilities shift over time. In one lifetime, a consumer can express a number of identities. It’s why the expectation of lifetime value (LTV) can be disengenuous at best.

There will always be natural attritition; retention is never 100%. But this isn’t about natural attrition. There’s a point in the lifecycle when a brand may lose its soul. It’s usually the case that it’s a result of a lean into hyper-growth. The decision to pursue performance-driven, hockey stick growth can lead to several changes in creative and managerial inputs. Those inputs have first, second, and third order effects that can be subversive to longterm growth.

Christopher Mims recently published a perspective [1] on Tumblr’s failures. In many ways, some DTC brands mirror that era of media. His report has a special relevance in today’s DTC space: The End of the ‘Eyeballs Are Everything’ Era.

But inherent in Tumblr’s structure, culture and even code base were, from the beginning, problems for any potential owner. On the business side, it operated under the assumption that it could make money off its users the same way people had since the invention of the banner ad: Build a big enough audience, and “monetization” will take care of itself.

Beyond his take down of eyeballs and the impracticality of optimizing for reach, consider the same strategies being observed in online retail. With performance arbitrage long past its prime, the value of funneling the majority of resources into Facebook and Instagram-driven marketing has become increasingly risky. Even so, the concept below is on the minds of many in DTC:

[x] pair of eyeballs x CRO = efficient ROA

If you’ve ever observed a digitally-native retailer’s site traffic, you’ll notice something shortly after that brand puts a fresh round of capital to work. Site traffic rises over the next quarter; a flood of eyeballs visit the site for the first or second time. It’s not uncommon to see a 20-40% bump in traffic vs. the monthly average. There’s a reason for this sudden spike. With traditional, institutional investment comes a few strings attached in the form of (highly) recommended milestones. Bolstering a brand’s performance marketing spend tends be a short-term band-aid over a gaping hole (a lack of demand).

The abundance of easy venture capital in DTC retail may be the root cause of the rise in customer acquisition costs. DTC brands have relegated proven brand marketing tactics to their second and third tier of marketing strategies. Instead, they’ve emphasized uninspired PPC advertising. They are searching for that quick uptick in sales and traction. And rightfully so. Brand founders often find themselves positioning for the next round of investment, a milestone that rarely existed for retailers before 2007.

Prior to the DTC era of retail, financing outcomes looked slightly different. This was before retail founders sought SaaS multiples and tech exits.

  • Build a profitable business and remain private
  • Build a valuable business and sell to private equity
  • Build a profitable business and IPO

In a recent report by Marketing Land [2], consultants discuss the abundance of Instagram advertising purchased by direct-to-consumer brands:

Recently, a colleague mentioned that she had noticed a significant surge in the number of Instagram ad placements. Conducting a quick test via her feed, she found ads accounted for 22% of 45 posts and 23% of 26 Stories. She isn’t alone. Peter Stringer, a Facebook and Instagram ads consultant is among the marketers we’ve heard from that have noticed an uptick in Instagram’s ad volume. Stringer noticed the increase at the start of 2019.

Instagram and Facebook are effective tools for reach. They are ineffective tools for depth. The traditional forms of top funnel and mid-funnel retargeting are designed to keep consumers in the sales pipeline, not to inspire them. This platform-driven sales strategy has influenced teams to pursue superficial styles of marketing communications.

Brand statements have shifted away from carefully crafted messaging and presence. Instead, DTC brands are beginning to focus solely on its products attributes. You’ll observe more SKU features than storytelling. You’ll see ads highlighting perceived technological advantages or even its value in comparison to their nearest competitors. Rather than shaping the medium to their message, messages have amended to the medium. Quality of advertising has fallen as a result. And like Facebook, Instagram is often the first interaction for many of these brands’ potential consumers.

Consider how much of Nike’s communications are devoted to the construction of the shoe or a tit-for-tat comparison to Adidas or Under Armour. Nike, like other traditional brands, focus on messaging and affinity. By the time a consumer is ready to consider a purchase, decisions are more irrational than rational. To the consumer,  the construction of the shoe means much less than it should. For instance, Nike didn’t miss a stride when their shoe exploded on a coveted athlete playing on national television. They have their brand equity to thank; Nike is arguably the best marketing company on earth. Their ability to make the world’s best equipment is up for debate.

DTC brands are further jeopardizing their brand affinity for that short-term uptick in sales. These brands used to be referred to as “challenger brands,” the types of companies that would one day upend their counterparts in traditional retail. As the number of DTC brands have reached the thousands, many of lost sight of that goal: to replace the brands of yesteryear. This, and not just to compete against other brands with similar funding and technological DNA. By losing sight of this, the advantage has shifted back to the incumbents. For them, marketing has become easier while DTC’s have suffered from heightened platform competition and prices that reflect as such.

The brands that have the best shot at winning over the longterm would do themselves a favor by revisiting the strategies that existed before retail was taken over by attempted SaaS multiples, cookie cutter agency processes, and new age strategies to reach millennials. These consumers are only slightly more receptive to digital-natives than they are to traditional brands.

Consumers are always switching their preferences, losing affinities, and forging new passions for new product communities. In a battle for eyeballs, it’s important to remember that the distance between seeing and buying is actually lengthening as noise increases. A top funnel, performance marketing-driven sale is not as sure of a bet as at was just a few years before. As digital media has begun to understand the new economy (depth over reach), DTC brands should certainly follow suit. Positioning for longevity must become a key performance indicator. That way, a brand is less likely to lose its soul for a quick uptick in sales.

Read the No. 328 curation here.

By Web Smith | About 2PM